As I warned earlier
About asset values and shadier parts of the financial system
On July 4th I wrote about the centrality of asset prices to financial stability. First, in this post on the role of Paul Volcker in inflating, and then deflating asset prices in the 1970s. Then on July 5th, I wrote about why “standing up” the case that asset prices are vital to financial stability, is important.
And so it has proved.
Today, asset prices are volatile, and many are falling. That will impact all of us. Because, as we know from past history, falls in asset prices are the cause of broader financial crises.
They were the cause of Japan’s descent into deflation after the collapse of an asset price bubble in 1989.
They were the cause of the Dot-com crash of 2000.
Of the US housing market bust in 2006/7.
And of the unprecedented market crash of March, 2020.
So get ready for a bumpy ride ahead.
FX Hedge posted this tweet this morning, 6 October, 2022.
Followed by this from Pete Sampras:
“Private assets give an illusion of price stability until you want to sell them.”
In other words only when you (or your pension fund) seeks to sell collateral or an asset - does the real value of the asset reveal itself.
So far, so common sensical.
Now why does the fall in the asset prices mentioned above matter to you, the reader? You may not be invested in Credit Suisse; you have probably never dined or enjoyed afternoon tea at the Savoy Hotel, let alone owned a share in it. Finally, you may not be bothered by what Goldman Sachs may be up to in the global market for private assets.
But you probably care about your pension fund.
As I write pension funds are selling assets (“at discounts of 20 to 30 per cent”) held as guarantees against their borrowing - their leveraged collateral - in order to raise cash to cover margin calls. And the more they sell, the faster the fall in the price of said assets, so the more that have to be sold.
Why are pension funds selling key assets including ‘gilts’ or bonds- to raise cash?
Anyone following the financial market chaos unleashed by the new UK Chancellor on Friday, 23 September will have heard of an arcane instrument at the heart of the turmoil that followed the Chancellor’s casual delivery of a ‘mini-budget’:
LDIs - or Liability Driven Investments.
[Watch out for LDIs - they may well become what CDOs (Collateralised Debt Obligations) came to represent, in the great financial crisis.]
While LDI instruments might seem arcane, their rise or falls have a material impact on pension funds.
The Bank of England (in a letter today to the Chair of the Treasury Select Committee) helpfully defined LDI strategies:
LDI strategies enable DB pension funds to use leverage (i.e. to borrow) to increase their exposure to long-term gilts, while also holding riskier and higher-yielding assets such as equities in order to boost their returns.
Pension funds need to invest our savings in such a way as to ensure pensions can be paid out in the future. The time lag between investment in a pension and the final pay-out day, makes it tricky to maintain or even increase the value of a pension fund over said period.
Pension funds invest in assets regarded as safe, in particular government bonds or ‘gilts’. If the price (value) of their assets were to fall, then to compensate, managers of pension funds hold riskier assets that make higher returns (like stocks and shares) - as a way of balancing any fall in the value of bonds.
LDIs enabled Defined Benefit schemes (i.e. those into which an employer pays a regular contribution fixed as a percentage of employee member’s pay) - to borrow in repo markets (‘shadow banking’ markets) to buy longer-term and safer bonds to match their investment in riskier equities…
What happened last week was that the price of that borrowing rose dramatically - as the yields (broadly interest rates) on gilts shot upwards.
This chart from the BoE shows just how dramatic were those changes in yields after the “fiscal event” of 23 September.
Why did yields ratchet upwards, you ask? The answer is straightforward: investors (both domestic and global) lost confidence in the management of UK PLC by Chancellor Kwarteng - and started selling holdings of UK government bonds (gilts).
As more bonds were sold into the market - so the price of bonds fell and yields rose.
In any case, the Bank of England had, on Thursday 22nd September, the day before the announcement of the ‘mini-budget’, signalled that in the near future the Bank itself would sell £80billion of gilts - as part of the Quantitative Tightening (QT) programme. I doubt that the Bank’s MPC would have made such an announcement if they had been made aware of the extra borrowing implied by the Chancellor’s mini-budget.
The markets reacted immediately, and negatively, to the Chancellor’s statement.
Panicky sales of gilts by for example Blackrock (see above) were amplified by both the statement, and by that signal from the Bank of England - even though the Bank had not begun its sales. Investors feared there would be a glut of bonds on the market, and their price would fall.
As an aside, and for another post: this cock-up (for so it is) reveals that the Chancellor had not consulted, or coordinated his announcement with the Bank of England. This lack of coordination between the monetary and fiscal arms of the British state have for a long time been a beef of mine, and many other good economists. But it is the economic ‘fashion’ for the BoE to be ‘independent’.
So there you have it. The prices of safe assets - against which pension funds, asset management funds and other private investors have leveraged additional borrowing - began falling - like Jenga blocks.
They did so, as bond yields rose. A consequence of rising bond yields was that mortgage providers took fright - worried that their cost of borrowing would rise, and that they would not be able to pass those costs on to borrowers. So nearly 1000 mortgage products were immediately withdrawn from the market. Rates for new mortgages (and for those renewing) rose in some cases to 6% threatening the viability of those mortgages.
On Wednesday 28 September, the Bank of England was forced to reverse course. Instead of selling bonds into an over-stocked market, the Bank embarked on a £65bn bond-buying programme to calm market panic. (By buying bonds, withdrawing them from the market, the Bank shrank the supply. That process made bonds more valuable, so prices rose, and yields fell.)
That worked to stabilise the market. For a while.
Today asset prices continued to fall. That fall in asset price valuations, combined with a rise in interest rates means a roller-coaster ride ahead.
Hold on tight in there, and keep safe.
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I am in awe how you manage to keep up your informative daily critiques on the awful state of Kwamikaze Trusseconomics 🤛👊